Scientifi c Frontiers and Technical Analysis Kevin P. Hanley, CMT 3 Abstract comments from the head of the economics department are unlikely to attract much undergraduate or graduate study to say the least. Ironically, “Anathema” is a Greek word originally meaning “something lifted up as an offering to the Are there scientifi c foundations to Technical Analysis (TA) or is it a gods” and “something sacred.” Worthy of note, Malkiel took aim at investment pseudo-science? Academia, embracing the Random Walk Theory, the Effi cient management professionals in general and not only technicians. He is best Market Hypothesis (EMH) and Modern Portfolio Theory (MPT) has argued known for writing that a “blindfolded monkey throwing darts” could pick the latter for some 20 years or more. In fact, according to current orthodoxy, better stocks than most money managers could. both TA and Fundamental Analysis are fruitless distractions and cannot add What is it about TA that warrants such disdain? John J. Murphy (1999) value. The advent of Behavioral Science has illuminated some of the fl aws in defi nes TA as “the study of market action, primarily through the use of charts, the standard model. Andrew W. Lo’s Adaptive Markets Hypothesis reconciles for the purpose of forecasting future price trends.” Murphy notes that TA has effi cient markets with human behavior by taking an evolutionary perspective. three key premises; namely, that market action discounts everything, price According to Lo, markets are driven by competition, adaptation, and natural moves in trends and history repeats. Martin J. Pring adds that TA “deals in selection. What is missing is a more accurate and comprehensive model probabilities, never certainties” and has “three essential areas: sentiment, fl ow of the market itself. Chaos and Complex system theories provide a more of funds, and market structure indicators.” comprehensive understanding of market behavior. The markets can be seen as chaotic, complex, self-organizing, evolving and adaptive, driven by human Although defi ned as an empirical science, leaders in the fi eld shy away behavior and psychology. Patterns in the market are emergent properties. from its scientifi c foundations stressing the art of the practice. Murphy Identifying these patterns has predictive value, but certainties must be left (1999) says, “Chart reading is an art.” Pring (2003) also concludes that TA is behind; only probabilities remain. TA, shown to be the inductive science of an art. Accomplished TA researcher, Professor Henry O. Pruden makes the fi nancial markets, is an essential tool for identifying these emergent properties subtle yet signifi cant distinction that the interpretation of technical patterns and analyzing their probabilities. Lastly, so that the science of TA may advance, is an “art form” (“Chart Analysis as Sequential Art,” Journal of Technical the fi eld must distinguish between scientifi c, empirically based, market analysis Analysis, 2004, #62). Aaron Task, in Technically Speaking, (2003, May), theory and the categories of interpretation and practical trading strategies. wrote, “Looking forward, I think the best thing MTA members can do is to stress the ‘art’ of chart reading over the science,” in response to Peter Kendall’s eloquent advocacy for the scientifi c aspects of TA. The “art advocates” do not want to defend TA scientifi cally. I. Art, Science, and Fallacies Most of the art vs. science debate arises out of confusion. In any fi eld, it is easy to confuse the practice or practitioners with the knowledge base. We see only what we know. An art is an applied knowledge or applied science. Recently, John R. Kirby Johann Wolfgang von Goethe seeking to clear-up the art vs. science debate, quoted highly regarded Technical Analyst Ralph Acampora: “‘Art’ means a skill acquired by experience, study, or observation. ‘Science’ is a body of knowledge with its own axioms, rules, Universities are the vanguard of emerging scientifi c thought. Yet, in the and language (Technically Speaking, 2005, January).” academic community, we fi nd that TA does not fare well. TA is largely ignored, From a scientifi c perspective, personality should not cloud empirical denigrated, or simply dismissed. In their well-respected paper, The Predictive evidence. However, the aura of a powerful personality can have a huge Power of Price Patterns (1998), Dr. Gunduz Caginalp and Henry F. Laurent, impact on a fi eld and some technicians have received substantial publicity for wrote, “The gulf between academicians and practitioners could hardly be wider making sensational predictions rather than measured projections. When these on the issue of the utility of technical analysis.” John Nofsinger, Assistant predictions have failed to materialize it has brought discredit to the fi eld. The Professor of Finance, Washington State University, recently confi rmed this academic community takes predictions very seriously and when a model fails perception, reiterating that there is “one of the greatest gulfs between academic to predict accurately, the underlying hypothesis is rejected. fi nance and industry practice (Peter Kendall, co-editor of the Elliott Wave Financial Forecast in Technically Speaking, 2003, April).” Looking past the sins of a few, the most common criticism of TA is that it is a self-fulfi lling prophecy. Typically, the argument goes like this: 1) Market Burton G. Malkiel, Professor of Economics, Princeton University, is patterns appear randomly; 2) Some investors use TA; 3) These investors one of the most prominent economists in the world. He authored the very respond to the same market patterns; 4) The investor response causes the infl uential fi nancial classic, A Random Walk Down Wall Street and is a markets to behave as the investors had anticipated; 5) The market response leading proponent of the EMH. With ties to the Vanguard Group, he is a vocal reinforces the believe that there is predictive value in TA; 6) It is investor advocate of indexing. In his book, Malkiel sets the tone for what has become behavior based on false beliefs that generates the anticipated market action. a prevailing attitude among academics: “Obviously, I’m biased against the chartist. This is not only a personal predilection but a professional one as The most obvious fl aw in the argument is that you cannot isolate the well. TA is anathema to the academic world.” “Anathema” means formally behavior of technicians from other investors in any accurate, empirical manner. set apart, banished, exiled, excommunicated, or denounced. These scathing Even if it were possible, it is illogical to think that the behavior of one group 20 JOURNAL of Technical Analysis • 2006, Issue 64 should be isolated from the behavior of all investors. The market, by defi nition, there were daily technical reports. Moreover, it would follow from Shiller’s is a function of all of its participants. Even if we were to assume all participants argument that TA would be signifi cantly more effective and infl uential today were technicians, it does not follow that all would act in unison. Aside from in the so called “Information Age” than it was 50 or 100 years ago, and that this obvious error, the argument has other logical fl aws. there should be, but is not, a progressive pattern of growing infl uence over Robert K. Merton formalized the structure and consequences of social time. Germane to Shiller’s thesis, history shows boom and bust cycles with behavior in his book, Social Theory and Social Structure (1968). Merton fi rst wild speculative market peaks and sudden crashes, but they occurred long taught at Harvard then became Chairman of the Department of Sociology at before a price chart was ever drawn. Shiller references Charles Mackay’s Tulane University, and eventually joined Columbia University in 1941. He classic, Memoirs of Extraordinary Popular Delusions and the Madness of coined the term “self-fulfi lling behavior,” as well as other popular terms such Crowds, written in 1841, he should have taken this into account. as “role model” and “unintended consequences.” According to Merton, “The Shiller is right when he says TA plays a contributing role in market self-fulfi lling prophecy is, in the beginning, a false defi nition of the situation movements, but he should have limited his argument to this point. It is accurate evoking a new behaviour which makes the original false conception come to say that TA may be a self-reinforcing force in the market and contribute to true.” Therefore it can be concluded from Merton’s defi nition that embedded investor expectations whether rational, nonrational, or irrational. However, it in the “self-fulfi lling prophecy” argument is the assumption that TA is based is illogical for Shiller to claim that technical principles are reinforced “solely on false beliefs. We can see the argument is circular: TA is based on false because people are using them” because that view cannot be empirically beliefs; therefore, it is false. Moreover, it is illogical to apply truth functions supported. to investor beliefs. Markets are a function of investor opinions and beliefs, The other most common critique against TA is that it is “too subjective.” regardless of the validity of those opinions or beliefs. Among experienced technicians, there is often disagreement about the Effi cient market proponents insist that the current price of a security is interpretation of a particular chart pattern. The fl aw is this argument is that the best estimate of its true value. Effi cient markets imply that self-fulfi lling there is a distinction between interpretation and a factual chart pattern. There prophecies as traditionally understood are impossible. Therefore, any is rarely, if ever, a disagreement over the facts of a chart or any other data set mainstream economists espousing the self-fulfi lling prophecy argument are to be analyzed.